5 Things to Know About Token Warrants

Venture capital investors in blockchain companies often require formal rights to receive tokens or other digital assets created by those companies. Typically, these rights are provided through an instrument called a “token warrant.” While token warrants are most frequently issued in priced rounds, they have become increasingly prevalent in connection with SAFE or other convertible rounds. Here are five things that any blockchain company or investor should know when evaluating token warrants:

1. Token Warrants Can Confer Broad or Narrow Rights. Companies and investors should pay close attention to the types of tokens that warrants entitle their holders to acquire. Token warrants may provide holders with rights to receive one specific type of token only, such as the first governance token issued by a company. However, token warrants typically provide holders with rights to receive any future tokens created or issued by a company or its affiliates – as well as any future tokens issued by an acquiror of the company’s intellectual property or any entity established by or on behalf of the company to issue tokens or operate a blockchain-based protocol or other technology associated with the tokens. Token warrants may also provide holders with rights to receive tokens created or issued by the company’s founders.
2. Exclusions May Apply. Token warrants often outline specific types of tokens that are not acquirable under the terms of the warrant. Often known as Excluded Tokens, they generally include tokens that are generated pursuant to mining, staking, or reward systems. Depending on the applicable company’s business, Excluded Tokens may also include non-fungible tokens, stablecoins, or certain tokens issued in the ordinary course of business. Typically, the company and its investors will negotiate what is considered an Excluded Token based on the company’s business model.
3. The Number of Tokens Issuable to Holders Can Be Calculated Several Ways. Token warrants specify the share of tokens holders can acquire under the warrant. This typically depends on three key variables:
   • The set of tokens from which the holder’s share is calculated: The holder’s share may be calculated from the number of tokens minted, from the number of tokens minted and issued to the company’s “insiders,” which includes the company’s stockholders and holders of its convertible or exercisable securities, or otherwise. In the “insider” structure, the holder would not be entitled to any share of tokens that are reserved for community members or other non-“insiders.” In addition, token warrants may provide holders with rights to tokens issued in inflationary events or in connection with other increases in the token supply.
   • How to calculate the holder’s share: The holder’s share may be a hard-coded percentage, but it is more typically based on the holder’s fully diluted ownership of the company. In the latter structure, the holder’s share will typically equal its fully diluted ownership as a percentage of the total cap table. But investors may negotiate a “super” pro rata share, which is a multiple (e.g. 1.25x, 1.5x) of the investor’s fully diluted ownership.
   • When to calculate it: The time at which a holder’s share is calculated can make a difference in how many tokens the holder has a right to acquire. For example, the holder’s share may be calculated as of the date of warrant issuance, the date of the applicable token launch, or the date the warrant is exercised.
4. “Lockup” Provisions Govern the Transferability of Tokens. Token warrants typically specify the “lockup” restrictions that will prevent holders from transferring tokens acquired under the warrant for certain periods. Lockup schedules in token warrants may include provisions that prohibit any transfers of tokens for one year after the tokens are acquired, release some tokens from lockup at the one-year mark, and then release the balance over successive monthly increments. For example, a lockup schedule may prohibit 100% of the tokens from being transferred until the one-year anniversary of the exercise date, and then permit the transfer of 50% of the tokens on the one-year anniversary and 1/24^th, 1/36^th or 1/48^th of remaining tokens over the next two to four years. A common provision requires an early release of the lockup provision if certain “insiders” (particularly founders or board members) have a less stringent lockup period. Token warrants may also provide the token issuer with rights to impose additional transfer restrictions on tokens in light of regulatory requirements or in connection with centralized exchange listing requirements.
5. Beware of Token Warrants that Compensate Service Providers. Token warrants are not ideal instruments for compensating a company’s service providers (e.g. employees, contractors, advisors). The Internal Revenue Code subjects deferred compensation – including token warrants – to a variety of complex and generally unfavorable tax, vesting and exercise rules. Therefore, companies should generally limit issuing token warrants to investors.